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Assessing risk and liquidity in the bond market

Certain types of bond offer the potential for greater returns – but are more risky than others. We explain what these bonds are and the risks you should be aware of.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please
seek advice. If you choose to invest the value of your investment will rise and fall, so you could get
back less than you put in.

Joseph Hill, Investment Analyst

6 March 2020

We believe bonds have an important part to play in a diversified portfolio. Over the long term, having a portfolio that invests in a mix of equities, bonds and other assets smooths returns through the market cycle.

As well as offering diversification, bonds usually pay a fixed rate of interest so can be useful in generating an income. Most bonds are viewed as ‘lower risk’ than investing in a company’s shares.

The easiest way for individual investors to get exposure to bonds is through a fund. Much like equity funds, these come in all guises, investing in different areas of the fixed income market to generate returns – offering exposure to different parts of the market, or areas of the world.

There are two main types of bonds – those issued by governments, and those issued by companies, called corporate bonds.

When companies issue debt they can choose whether to pay a credit ratings agency to ‘rate’ their debt or not. A credit rating helps investors determine how risky the investment is by providing an independent, objective assessment of the creditworthiness of a company and ultimately, its likelihood of being able to make the promised payments.

A high credit rating indicates a strong probability that the borrower will be able to meet its financial commitments in the future, which will include keeping up with interest payments and repaying the loan at the end of its term.

A low credit rating means that there’s a higher chance that the company could default and be unable to meet its obligations. It’s important to note though that the credit rating expressed is an opinion of the ratings agency and shouldn’t be considered as a guarantee of future events.

Unrated bonds

Some businesses choose not to obtain a credit rating when issuing debt. This can be for a number of reasons – they may feel that the issuance is too small to warrant a rating, or that the cost of obtaining a rating is too high. When issued without a rating, a bond is referred to as unrated. Without a rating though, it’s more difficult for investors to assess the credit quality of the company and ultimately the risk of default.

Because of the lack of rating, there are fewer analysts covering these types of bonds, and ultimately a smaller number of investors. This means that it can be harder to buy and sell unrated bonds, creating what is known as liquidity risk.

High yield bonds

Companies that are less financially secure, and so have a higher risk of defaulting on their debt often need to offer higher yields to investors to compensate them for the extra risk taken by lending them money. As a result, these kind of bonds have the potential to perform differently to other areas of the bond market.

This area of the market has performed well recently. In 2019, higher-risk high yield bonds delivered the best returns over the year out of all of the major Investment Association (IA) bond sectors with annual returns of 11.5%*, although this isn’t a guide to the future. In a downturn, they would be unlikely to offer shelter and we’d expect them to be more volatile. *Source: Lipper IM to 31/12/2019.

Adding risk for potential returns

Eric Holt, manager of the Royal London Sterling Extra Yield Bond fund invests in areas of the market that most other investors overlook, including unrated and higher yielding bonds which adds risk. He believes these areas offer opportunities to exploit inefficiencies in the credit market. The liquidity of unrated bonds is often lower and issuers have tended to pay a premium to the yields on rated bonds to help compensate investors for the extra uncertainty associated with holding them. Holt and his team are experienced in investing in more unfamiliar areas and hold a wide range of bonds so the funds returns don't rely on a single holding, however because of the greater liquidity and default risks associated with both unrated and high yield bonds, we would consider the fund to be an adventurous option.

As this is an offshore fund investors are not normally entitled to compensation through the UK Financial Services Compensation Scheme.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek
advice. If you choose to invest the value of your investment will rise and fall, so you could get back
less than you put in.

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Our website offers information about investing and saving, but not personal advice. If you're not sure which
investments are right for you, please request advice, for example from our financial
advisers. If you decide to invest, read our important investment notes first and
remember that investments can go up and down in value, so you could get back less than you put in.